Indices as Benchmarks

When using ETFs, it is important to understand how the underlying index or benchmark is constructed.

There are many different types of indices that make up benchmarks and it is important to understand how each is constructed as different indexing methodologies can generate different returns.

The most common methodology is the traditional market-capitalization weighted methodology whereby each index constituent is weighted by its market capitalization (market capitalization = number of shares x market price). This means that larger companies carry more weight in the index than do smaller companies. The equal weighting methodology eliminates this inherent larger company bias by opting up front to allocate the same percentage of exposure to each individual security comprising the index. This results in an exposure where mid and small capitalization companies will have a greater representation, and thus impact on the index and its performance.

The fundamental indexing methodology arose in response to the belief that there is a tendency for stock prices to deviate from a company's true – or "fair economic" - value. Unlike the traditional market-capitalization weighted indices which rely on “price-weighting”, the fundamental indexing methodology determines a stock’s index weighting on the basis of fundamental factors such as earnings, dividend payouts or valuations such as price to book and price to sales. These indices are often referred to as "rules-based".

Beyond these methodologies, a new type of customized strategy-based index has evolved, often referred to as "smart" indexing or "intelligent" indexing because these indices strive to reflect a customized strategy. This methodology mimics active management in that it screens for specific factors or incorporates a specific strategy in an attempt to outperform more traditional benchmarks. Relative to active management though, it is important to note that smart or intelligent indices are rules-based, with clear rules and criteria, not subject to the “override” active management could introduce. In other words, the rules and criteria are implemented and followed, without being subject to additional discretion. A truly active management style may opt to disregard rules and criteria, and use discretion to reflect the manager’s views at the time.

One thing to bear in mind is that with any index the frequency of rebalancing will affect returns. Some indices are reconstituted on a monthly basis, while others may be quarterly, semi-annually, annually or not at all. Frequency of rebalancing can also have an impact in terms of costs and tax considerations.